CLASSIFICATION OF COSTS,

PROFITS, CONTRIBUTION

Costs
Quick Quiz
Cost Centres and Profit Centres
Case Study

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 Costs, Profit, Contribution
and Break-Even Analysis
Cost Classification and Cost Allocation
In order to make meaningful decisions a manager
must have cost data for each product, department
and function of the business
The problem with this is how to accurately define
the costs and how to allocate the costs to the
various products and departments

The management accountant classifies costs into

fixed and variable costs or direct and indirect costs

These costs are then allocated as accurately as

possible to the cost centres that generate them. In
this way centres are made aware of their
responsibility to control costs
Fixed, Variable and
Semi- Variable Costs
Variable Costs – expenses that alter in the
short run to changes in output e.g. raw
materials, packaging and components. They
are payments for the use of inputs

Fixed Costs – expenses that do not alter in

the short run in relation to changes in output
e.g. rent, insurance and depreciation. These
costs are linked to time rather the level of
business activity

Semi Variable Costs – expenses that vary

with output but not in direct proportion e.g.
maintenance costs. They often comprise a
fixed element and a variable element
 Direct and Indirect Costs

Indirect Costs – costs that cannot

be allocated accurately to a cost
centre or product e.g. administration
costs, management salaries or
maintenance costs. Another term for
this is overheads

Direct Costs – costs that can be directly identified with a

product or cost centre. They are mainly variable costs but can
include some fixed costs e.g. the rent of a building solely used
for one product. They are also referred to as prime costs
 Total Cost
Total Cost – this is the addition of all fixed and
variable costs (plus any semi-variable costs)

Where fixed costs form a significant part of

total costs it is important for a business to
maximise sales so that the fixed cost
element is spread across as many units as
possible

The total cost is used by the business to

see how much finance is required for each
level of output
Average Cost / Selling Price Per Unit

Average Cost – this is the cost per unit of production and is found by
dividing total cost by total output. Average cost can be used to establish
the basic price level by adding on a suitable mark-up

For example:
Variable costs are £10 per unit of production
Costs for 1,000 units are:
Fixed Costs £20,000 (These do not increase with production)
Variable Costs £10,000
Total Costs £30,000
Average Cost per unit = £30,000 / 1,000 units = £30 per unit
Average Cost Per Unit + Percentage Mark-up = Selling Price
£30 + 50% = £45
Total Revenue / Contribution Per Unit

Total Revenue – This is the amount of money a business

receives from selling its products. It is calculated by multiplying
the number of units sold by the the unit price

Contribution Per Unit – This is the difference between the

selling price per unit and the variable cost per unit

For example:
Selling Price Per Unit £20
Variable Cost Per Unit £10
Contribution Per Unit £10
Contribution is used to pay the fixed costs and generate a profit
 Break-Even Analysis /
Margin of Safety / Profit
Break-even provides the firm with its first target i.e.
covering all of its costs. Any sales beyond the break-even
point (BEP) will then generate a profit

For example: A firm has fixed costs of £100,000, variable costs (VC) of £10
per unit and a selling price (SP) of £20 per unit.
BEP = Fixed Costs / Contribution per unit (i.e. SP – VC)
BEP = £100,000 / £20 - £10 = 10,000 units

The Margin of Safety (MOS) is the difference between the planned level of sales
and the BEP. If the firm planned to sell 12,000 units. The MOS would be 12,000 –
10,000 = 2,000 units
Thus the profit for the firm would be 2,000 units x £10 contribution per unit
= £20,000

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 Quick Quiz
Q1 Which of the following fixed costs does not affect cash flow?
Rent
Insurance
Depreciation

To make 1 unit of product X the following are required:

Material Costs:
2 kg of raw materials at £5 per kg
Packing costs at £4 per unit
Labour Costs:
2.0 hours of machining time at £10 per hour
1.5 hours of finishing time at £8 per hour

What is the total variable cost of making 1 unit of product X?

What is the total variable cost of making 1,000 units of product X?
 Quick Quiz
Q2 A firm has the following fixed costs:
Rent £5,000 Rates £4,000
Insurance £3,000 Depreciation £8,000
It makes and sells product X – the variable costs are £10 per unit.
What is the total cost of making 1,000 units?
What is the total cost of making:
2,000 units 5,000 units 10,000 units 20,000 units

Q3 What will be the selling price per unit if production is increased from
1,000 to 2,000 units and the mark-up is increased to 75%?

Q4 Using the information from the previous quiz – calculate the total
revenue generated from the sale of 1,000 units and 2,000 units.
 Quick Quiz
Q5 A firm has fixed costs of £200,000 – variable costs of £20 per unit and
a selling price of £40 per unit. It plans to make and sell 15,000 units.

What is the contribution per unit?

What is the break-even point?
What is the margin of safety?
What is the total cost of making
15,000 units?
How much sales revenue will be
generated by selling 15,000 units? How much profit will be generated if the
firm achieves its sales target?

Draw a break-even chart showing the above information.

Repeat the exercise – assuming one change – the firm

plans to make and sell 20,000 units.

Exit
 Cost centres and profit centres

The Changing Nature of Business – Globalisation of

business, a higher rate of product obsolescence (due to
rapid technological developments) and the increased
sophistication of consumers has led to increased
competitive pressures within all markets

The Impact of Increased Competition – The major impact of this development

has been the drive for all firms to reduce their costs. The most effective way to
achieve this objective is through economies of scale

Mergers and Takeovers – In all industries there has been increased activity with
regard to takeovers and mergers. This means that there are fewer firms but now
they operate on a global basis thus generating large economies of scale and
reduced costs
Cost centres and profit centres
The Disadvantages of Becoming A Global Operator

 Decision making becomes centralised

 As the company grows the decision makers

become isolated and lose touch with the
customers

 Increased size makes communications and

decision making much more complex

 The company loses touch with the market place and becomes de-
sensitised to changes occurring within the external environment

 The company becomes complacent and loses its innovative drive

 Cost centres and profit centres
Delegated Decision Making - this provides the
means to overcome the problems caused by
becoming a global operator

How? – Proctor and Gamble plc is a global

operator. However, it is not simply one company. It
is actually a large number of companies (100+)
which make up the Proctor and Gamble group

Autonomous business units – this simply means

that each company within the Proctor and Gamble
group is allowed to operate as an independent
company

The directors of each company must comply with

corporate standards and supply reports on their
performance (e.g. costs, sales and profits) on a
periodic basis (e.g. quarterly, annually) to the main
board of directors
 Cost centres and profit centres
The principle of delegated decision making can then be applied to each
company. This is achieved by subdividing each company into profit centres
and cost centres

A profit centre could be a retail outlet, a brand, a sales force operating in a

geographical location e.g. the North East of England etc. Each profit centre
will have a manager who is responsible for ensuring that sales and profit
targets are achieved. He must also ensure that costs are kept within the
stated budget limits

The manager of a cost centre is only

responsible for keeping costs within stated
budget limits. He has no responsibility for
sales or profits
Cost Centres and Profit Centres

Cost Centres are sections of a business to which costs can be charged

A cost centre in a manufacturing business, for example, is

a department of a factory, a particular stage in the
production process, or even a whole factory

In a college, examples of cost centres are the teaching departments, or

particular sections of departments, e.g. the administrative office

In a hospital, examples of cost centres are the hospital

wards, operating theatres, and specialist sections such as
the X-ray department, pathology department
Cost Centres and Profit Centres
A Profit Centre represents a segment of a business to which
separate activities can be analysed

It generates revenues and incur costs and is a convenient

business unit for the analysis of profit which are generated by
various activities

A designated manager will be responsible for the successful

running of the profit centre

The manager will be given the authority to make decisions

within specified limits (delegated decision making)

Delegated budget is the amount of money the manager can spend without
having to refer to a higher level manager for approval

e.g. for a 12-month period, a manager could have a £200,000 budget and could
spend a maximum of £20,000 on any item without having to seek prior approval
 Case Study

THE SITUATION – Your name is The company has recently been taken
Edward West and you are the over by Proctor and Gamble (P&G).
Managing Director of West However, the current board of directors
Perfumes Ltd (WPL). This is a are being allowed to remain in control.
family business and produces P&G are investing £5m in West Ltd to
scented perfumes, which are sold to finance the development of new
a wide range of different retailers products and upgrade its
e.g. John Lewis, Marks and manufacturing equipment.
Spencers etc.

However, P&G want sales and profits to increase by 30% within the next 12
months. You have also been told to reduce the workforce by 20%.

From the viewpoint of West Perfumes Ltd, what are the advantages and
disadvantages of the P&G takeover?
 Case Study

Management Accounting is concerned with providing the management of a

business with financial recommendations, based on costing information, e.g. the
cost of materials, labour, overheads etc, in order to enable day-to-day and
longer-term plans to be made

Management accounting uses information from past transactions as an aid to

financial decision making, planning and control for the future

The management of a business needs information from which to work. It needs

to know accurate costs of individual products or services, together with the total
costs of running the business

WPL’s labour costs are 20% higher than the average for a P&G company. Why
is this figure of significance? What action can be taken to reduce this figure?
What will happen if nothing is done to reduce labour costs?
 Case Study

A complex of machines may act as a

cost centre, and in turn the factory
departments in which the machines
operate can also be cost centres

But the factory itself may be a profit

centre, its manager being responsible
for sales as well as production

Explain why WPL is a profit centre for P&G?

Explain how P&G’s organisational structure overcomes the disadvantages

of being a global operator?

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